2/12/2010 @ 7:25PM

Fed Chooses To Try Unwind Via Eye Of Needle

Ben Bernanke is making sure the Federal Reserve’s exit strategy goes as easily as a camel can pass through the eye of a needle. Instead of choosing simply to sell assets and unwind the securities it holds, the Fed chairman is seeking to be creative once again–as he was in the buildup of its balance sheet–and increase the amount of interest it pays on excess reserves.

“It is possible that the Federal Reserve could for a time use the interest rate paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, while simultaneously monitoring a range of market rates.” Bernanke said in a statement prepared for the House Financial Services Committee that was released Feb. 17.

At issue is the fact that, to prevent intractable inflation, the central bank must at some point shed most of the $1.43 trillion worth of housing debt it will own by the end of March. The Fed’s balance sheet has increased to $2.25 trillion from $925 billion since the start of 2008. What’s more, excess reserves in the banking system now total more than $1 trillion.

Excess reserves are defined as commercial bank deposits placed with the Fed that are not required to be held against loans. By paying interest on these central bank deposits, the Fed can raise the interest rate on interbank lending because loans to other banks are intrinsically more risky than loans given to Mr. Bernanke. This, in turn, can act a speed bump for the financial system, and possibly for inflation.

There are major flaws with this strategy, however. The Fed pays interest on reserves with yet more deposits held at the central bank. Therefore, paying interest on reserves further increases commercial bank deposits held at the Fed, and those new deposits will accrue interest as well and so on. As a result, by choosing to defer from selling assets and draining liquidity from banks, the Fed will ensure that the unwinding of their balance sheet will take many years to complete.

Projections from the St. Louis Federal Reserve are that it will take five to seven years for the central bank to unwind the mortgage backed securities (MBS) on its balance sheet. Bernanke is effectively betting that during this time banks will not make more profitable loans to consumers and enterprises and will instead opt for the lower returns garnered from Fed deposits.

Another risk that arises from deciding not to sell assets comes through the process know as sweeping. Banks currently have the ability to sweep money into Money Market Funds and time deposits. Because such accounts have no reserve requirements, they enable commercial banks to create a tremendous amount of loan growth and new money.

By concentrating on paying interest on reserves, Bernanke not only ignores the critical need to dramatically reduce the Fed’s balance sheet but also fetters his ability to increase the interest rates to a level that would attenuate rampant loan growth. In other words, since paying interest on reserves also increases reserves, there is a limit to how much the Fed can pay on deposits.

The Fed chairman also made it clear that any future asset disposals will come at a snail’s pace. “Any such sales would be at a gradual pace, would be clearly communicated to market participants and would entail appropriate consideration of economic conditions,” he said.

The most import factors in keeping inflation and money supply growth quiescent are to remove most of the excess reserves held at the central bank and to raise interest rates to keep the demand for loans in check. And it is the cost of money that is the most import governor of inflation. After all, it was not a massive buildup in reserves that caused the housing bubble. It was exceptionally low interest rates for an extended period of time that caused consumers to dramatically increase debt loads and banks to substantially boost the availability of credit. By focusing primarily on increasing the interest rate on deposits held at the Fed to keep prices in check, Mr. Bernanke misses the key factors behind money supply growth and inflation.

Investors who think Chairman Bernanke will fail in his bid to head off inflation should consider inflation hedges, like shorting the long end of the Treasury curve with ProShares UltraShort 20+ Year Treasury ETF (TBT) and buying energy stocks with a dividend like
Penn West Energy Trust
.

Michael Pento is chief economist at Delta Global Advisors and a contributor to greenfaucet.com.